DigitalOcean (DOCN -1.76%) has been a divisive investment ever since it went public in March 2021. The bulls claimed it could carve out a niche in the crowded cloud infrastructure market by doling out tiny "droplets" of servers for small to medium-sized businesses, while the bears believed it would be rendered obsolete by its larger competitors.
The bulls bid DigitalOcean up from its initial public offering price of $47 to an all-time high of $130.26 in November 2021. But rising interest rates and other macro headwinds brought back the bears, and today, its shares trade at about $34. To see if the stock is worth investing in now, let's weigh seven reasons to buy the stock against one reason to sell it.
Image source: Getty Images.
1. Robust revenue growth
DigitalOcean's revenue rose by 25% in 2020, 35% in 2021, and 34% to $576 million in 2022. It's expecting 21% to 25% growth in 2023, even as macroeconomic headwinds drive companies to rein in their spending on cloud infrastructure services.
Management initially forecast that the company would generate more than $1 billion in revenue by 2024, but it pushed that target back to 2025 last quarter to reflect the near-term challenges. However, that revised estimate implies the company can still grow its revenue at an impressive compound annual rate of at least 20% from 2022 to 2025.
2. Accelerating customer growth
DigitalOcean's number of customers grew by 6% in 2020, rose another 6% in 2021, and increased by 11% to 677,000 in 2022. Its customer growth accelerated over the past year even as cloud infrastructure giants like Amazon Web Services (AWS) and Microsoft's Azure, which both primarily serve larger companies, suffered slowdowns.
3. Stable growth in average revenue per user
As DigitalOcean's customer base expanded, its average revenue per user increased by 19% in 2020, 25% in 2021, and another 25% to $75.19 in 2022. Management attributed that robust growth to the resilience of smaller businesses, which adopted more of its cloud-based services as they scaled up their operations.
4. Rising retention rates
DigitalOcean's net dollar retention rate, which gauges its year-over-year revenue growth per existing customer, increased from 103% in 2020 to 113% in 2021, then expanded again to 115% in 2022. That stickiness suggests it won't be crushed by Amazon, Microsoft, or any other cloud giants anytime soon.
5. Expanding margins
DigitalOcean is still unprofitable on a generally accepted accounting principles (GAAP) basis. But on a non-GAAP basis, its margins have all been expanding.
Between 2020 and 2022, its adjusted gross margin rose from 76% to 80%, its adjusted operating margin expanded from 4% to 18%, and its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margin increased from 30% to 34%. Its free-cash-flow (FCF) margin, which came in at negative 18% in 2020, improved to 6% in 2021, and more than doubled to 13% in 2022.
For 2023, DigitalOcean expects its adjusted EBITDA margin to rise to between 38% and 39% as its FCF margin exceeds 20%. It had originally expected its FCF margin to reach 20% by 2024. It attributes that ongoing expansion to its first-ever price hikes (which it accomplished without losing customers), an upcoming 11% reduction to its workforce, new features to boost revenue per user, and cost-cutting synergies from its acquisition of Cloudways last September.
6. A short-squeeze candidate
DigitalOcean's stable growth pokes a lot of holes in the bearish thesis, yet 23% of its float was still being shorted as of March 30. It might be a good short-squeeze candidate if a new bull market drives investors toward growth stocks again.
7. Insiders are buying up the stock
Over the past three months, DigitalOcean insiders bought more than four times the number of shares they sold. That warm insider sentiment suggests the stock could be a bargain relative to its long-term prospects.
The one reason to sell: The stock could still get cheaper
With an enterprise value of $4.3 billion, DigitalOcean trades at about 6 times this year's expected sales. That makes it fairly cheap relative to other companies with similar growth rates. For example, ServiceNow, which is expected to grow its revenue at percentages in the low 20s for the next few years, trades at 10 times this year's expected sales.
But DigitalOcean could still get cheaper if the macro headwinds intensify. For example, Twilio, a cloud software company that saw its annual revenue growth decelerate from percentages in the 30s to the low teens, trades at less than 2 times this year's sales. In other words, DigitalOcean's valuation could still be cut in half if it falls short of its long-term goals.
DigitalOcean is still a worthwhile investment
DigitalOcean is a risky stock, but its robust sales growth, sticky retention rates, and expanding margins all suggest it will continue to expand in the shadow of AWS, Azure, and other large cloud infrastructure platforms. The stock isn't a screaming bargain yet, but it might be a multibagger if it continues to grow its revenue by at least 20% each year.
